Are you ready for a new lease accounting standard?

(First of two parts)

By John T. Villa

First Published in Business World (8/26/2013)

The International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) (collectively, “the Boards”) released in May 2013 their revised exposure draft (ED) on lease accounting primarily to address the concerns raised on the original ED issued in 2010. Among the highlights of the revised ED are:

1. The Boards propose requiring lessees to recognize on the balance sheet the assets and liabilities arising from most leases.

2. All entities would classify leases to determine how to recognize lease-related revenue and expense. Such classification would affect what lessors record on the balance sheet.

3. The lease classification criteria would be based on the portion of the economic benefits of the underlying asset that is expected to be consumed by the lessee over the lease term.

On-balance sheet treatment

The most significant criticism to the current system of lease accounting is probably the off-balance sheet treatment of operating leases. In order to address this, and consistent with the original ED issued in 2010, the revised ED fundamentally changes lease accounting for most lessees and lessors.

Companies that currently apply operating lease accounting to their equipment leases (e.g., aircraft, telecommunications, transportation, port operators and mining) may experience a significant financial statement impact because of proposed changes to both their balance sheets and income statements. While lessees of real properties may not see a significant change to their income statements, their balance sheets will be grossed-up.

Significant judgments and estimates involved

The revised ED will require companies to inventory and evaluate their present arrangements, and determine how the proposal would affect their balance sheets as well as the amount, timing and classification of lease-related revenues and expenses to be recognized. Among the relevant questions to ask are:

Which arrangements would qualify as or contain leases?

The definition of a lease (i.e., a contract in which the right to use an asset is conveyed for a period of time, in exchange for a consideration) is generally consistent with current lease accounting. However, the Boards changed the ‘right to use’ part of the definition. This complicates the analysis in situations when both the lessee and lessor have some rights over the underlying asset. Determining which party has the right to control the use of the underlying asset could be subjective.

In addition, accounting for operating leases and service contracts is often similar (i.e., straight-line). However, under the revised ED, it would be critical to identify arrangements as leases (or that have a lease component) in light of the new accounting proposal for leases, which can result in either an accelerated or a straight-line revenue and expense pattern on the income statement.

How should leases be classified?

The revised ED sets forth a principle for lease classification that is based on the portion of the economic benefits of the underlying asset expected to be consumed by the lessee over the lease term. To reduce complexity, the classification requirements would be based on whether the underlying asset is a property (i.e., land, building, or part of a building) or non-property (e.g., equipment, vehicles).

Leases of assets that are considered non-property are classified as Type A leases, unless:

a. The lease term is for an insignificant part of the total economic life of the underlying asset; or

b. The present value of the lease payments is insignificant relative to the fair value of the underlying asset.

On the other hand, leases of property are classified as Type B leases if:

a. The lease term is for the major part of the remaining economic life of the underlying asset; or

b. The present value of lease payments accounts for substantially all of the fair value of the underlying asset.

Under the revised ED, Type A leases would generally result in accelerated expense recognition for lessees and an approach somewhat similar to today’s finance lease accounting for lessors. Type B leases, on the other hand, would result in straight-line lease expense for lessees and an approach similar to today’s operating lease accounting for lessors. While the Boards have provided certain examples to help users classify leases, there are no clear guidelines, so applying the revised ED is not straightforward and could require judgment.

How to determine the lease term?

Lease term would include the non-cancellable period, plus optional periods for which there is a significant economic incentive for the lessee to extend (or not terminate) the lease. The proposed definition of lease term is similar to current lease accounting.

Assessing whether a significant economic incentive exists would continue to require judgment, and require lessees and lessors to establish processes and policies to foster consistent application. In addition, companies would need to reassess the lease term on an ongoing basis (e.g., when there is a significant change in the ‘economic incentive’ evaluation). This re-assessment is not required under current lease accounting. Relevant factors to consider when evaluating whether the lease term has changed include asset, contract and entity-based factors. Market-based factors would also be considered but would not, in isolation, be determinative when evaluating whether the lease term has changed. Reassessment of lease term could be subjective.

What should be included in lease payments?

Lease payments would include fixed and variable payments based on an index or rate (such as the Consumer Price Index or London InterBank Offered Rate). In addition, lessees would need to include amounts expected to be payable under residual value guarantees similar to current lease accounting. Termination penalties and purchase option payments are included if they are due based on the assessment of the lease term.

Variable rents based on performance or usage will be excluded from lease payments and recognized only when they are incurred or earned. Companies would also need to reassess variable payments based on an index or rate at each reporting period to consider the effect of any change in the index or rate.

Are there non-lease components that need to be separated?
Until now, many companies may not have focused on separating non-lease components (e.g., services) from their operating leases because today’s accounting treatment for lease components is often the same as the treatment for non-lease components.

Under the revised ED, lessees are required to separate non-lease components from the lease when observable stand-alone prices for one or more of these components are available. If non-lease components are not separated, they are treated as leases and included in the calculation of lease-related assets and liabilities.

Separation of non-lease components would require judgment. Lessees may need to develop processes to identify observable stand-alone prices for the lease and non-lease components. Unlike lessees, lessors are always required to separate non-lease components because lessors are expected to know the prices of the components of lease contracts they enter into.

For lessors, what is the fair value of the underlying asset at lease commencement and the estimated residual value at end of the lease term?

Lessors will need to estimate the fair value of the leased asset at lease commencement, as well as the residual value at the end of the lease term. Fair value estimates may become more important for leases that are accounted for as operating leases under current accounting, but would be considered Type A leases. An example would be the lease of an old train, with a lease term equivalent to 50% of the remaining economic life of the asset. This might qualify as an operating lease under current accounting but would qualify as a Type A lease under the revised ED. Under current accounting, fair values are used primarily to determine lease classification. However, under the revised ED, the fair value of the leased asset at the beginning of the lease term would affect not only lease classification, but also the amount of profit or loss initially recorded.

Additionally, the estimated residual value at the end of the lease term will affect the amount of interest income recognized by the lessor over the lease term. Additional processes for arriving at these estimates would be required.

In the second part of this article, we will look at the additional data that must be gathered and managed to comply with the guidelines of the revised ED.

John T. Villa is a Partner of SGV & Co.

This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the author and do not necessarily represent the views of SGV & Co.